~ Investment Strategy

Morning Note 13/01/12

Mario Draghi cheered everybody up yesterday by saying that the ECB’s actions had averted a “serious credit contraction” across the Eurozone in Q1 (as I said on Monday), and alleviated a crunch that was already visible in some areas. The amount of LTRO lending corresponded with the amount of bank funding coming due. He pointed out that the unsecured interbank bond market, which froze up in July, is showing tentative signs of life, although there is still a long way to go. He said that monetary policy was, and would remain, accommodative — and, consistent with this, said that a further rate cut had not been discussed by the board. He also pointed out — as I have said repeatedly — that the high level of deposits at the ECB is simply the result of an expansion of the asset side of the ECB’s balance sheet and not in itself evidence that banks are not lending to the real economy. Indeed, he also pointed out that the largest users of the deposit facility were generally not the banks that had taken the most in the LTRO. Asked if he would continue to buy bonds, Mr. Draghi said that the justification for the purchases was to keep the monetary policy channel open, and that the interbank market was still not functioning and unsecured lending was only beginning to come back. I take this to mean “yes”. The vice-president confirmed that the ECB remains opposed to Greek restructuring. Mr. Draghi said that the EBA stress tests had proved to be “pro-cyclical” and that there was “no probability” that the same exercise will be repeated in the future. I am not sure whether this means that banks are unlikely to be forced to raise as much capital as everybody fears, or not.

It may be that the market is coming to understand just how much the ECB has done for the Eurozone, and MD’s comments have helped in that regard. That would explain the positive reaction to Draghi’s comments and the continued falls in the EURIBOR-EONIA spread (and indeed a general decline in swap spreads across the curve). The ECB will do another 3-year LTRO in February, and in addition there will be several 1-year and 3-month LTRO’s between now and June, and regular 7-day MRO’s, all with full allotment (i.e. you get as much as you ask for). That means that banks are unlikely to have any funding problems for some considerable time.

The debt ceiling needs to be raised again in the US, but it will happen under the terms of August’s agreement. Congress can vote to block an increase, but such a move would be unlikely to clear the Senate, and if it did, then Barack Obama could veto the measure and the debt ceiling would be raised. This all provides a chance for politicians to make a racket, but not a chance for the ridiculous Republican party to play chicken with the economy.

Oil dropped yesterday after Bloomberg reported that sanctions on Iran’s oil may be delayed. The EU might delay for six months — Greece wanted a year — and Japan will also take some time to find alternative sources. China is taking its time, opposing the current US action while talking to Saudi Arabia (Wen is visiting this week I believe). China buys 22% of Iran’s oil exports. The Saudis, for their part, have said that they will keep the oil market well supplied, but whether they could replace Iranian production to the extent required by a proper sanctions regime remains to be seen.

China’s FX reserves had their biggest monthly fall — which indicates they had to prop their currency up rather than keep it down — since 1998 in December. I had a sense that this might be happening because I have been looking at the spread between the onshore (manipulated) and offshore (floating) Chinese currency markets (CNY and CNH, respectively). CNH went to a big discount to CNY at the end of last year, suggesting capital outflows from China. I was not sure how useful the spread was as an indicator, but the latest data suggest it has some use. Using monthly data since 2010 (the longest available), the relationship between the spread and the monthly change in China’s FX reserves has been relatively strong (R2=0.53, N=17).